Money for nothing?

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By Ram Kelkar, Joy A. Schwartzman, Gary Wells | 29 September 2008

The current credit crisis has turned the global financial markets upside down and inside out. The implications continue to emerge.

We asked Ram Kelkar, Joy Schwartzman, and Gary Wells for perspective on what this means to insurers.

Q: What can insurance companies learn from this crisis and how can they incorporate that information into their enterprise risk management models?

Kelkar: This crisis has underscored the obvious but often ignored importance of independent credit evaluation and modeling of all investment assets without over-reliance on rating agency or sell-side investment-bank analysts and their models. Many of the securities created in recent years had complex structures that could only be valued based on models created by the very financial institutions selling them, an obvious conflict of interest. We've also learned a lesson about the importance of limiting leverage, which can multiply the underlying loss of value manifold. The structural leverage within complex securities such as collateralized debt obligations (CDOs) was often ignored because the very structure of these products had the effect of masking the sizable risk embedded within them. Off-balance-sheet accumulation of risk based on exotic derivatives structures that are difficult to value or that rely on assumptions about continuous market access and liquidity should be treated with appropriate prudence by investors.

Q: State insurance regulation has come under fire. What role, if any, might the federal government take in regulating insurance going forward?

Schwartzman: With the Federal Reserve on the hook for any bailout, there will no doubt be an elevated level of debate concerning the need for at least partial regulation of insurers by the federal government related to transparency of exposures and improved risk analysis.

State insurance regulators, however, have a strong argument for maintaining the current regulatory oversight. AIG’s insurance entities remain well-capitalized. It was AIG's Financial Products Division—a noninsurance entity and, hence, outside the domain of state insurance regulators—that was undercapitalized. State insurance regulators have already begun to comment on the success of state regulation. They argue that any failure in regulation happened at the federal rather than state level.

Adding fuel to the fire, we've seen fingers pointed at the SEC based on claims that lax regulation of investment banking transactions and low capital requirements have contributed to the recent fallout.

While we know that there will be calls for stricter insurance regulation, the idea that it will reside at the federal level is not an obvious improvement. However, the unprecedented size of the bailout may sweep insurance under the federal regulatory purview.

Q: What effect, if any, will the current financial crisis have on the decision to replace U.S. GAAP accounting with IASB IFRS?

Kelkar: The SEC has recently announced its decision to establish a road map for shifting U.S. companies from GAAP to IASB International Financial Reporting Standards (IFRS). The IASB has a Fair Value Measurement Project underway and the deliberations will inevitably take into account lessons from the current market environment in arriving at any conclusions.

The IASB also has a project underway for fair valuing insurance liabilities, which may incorporate a "current exit value" standard. Insurers may find that the challenges faced by U.S. investors in valuing illiquid structured securities may now show up in the valuation of insurance liabilities.

The result? Insurance firms may have to assign a market value to insurance liabilities such as life insurance or fixed annuities, even though there is no real market where these contracts are actively traded.

Wells: This crisis will probably delay the decision to move from U.S. GAAP to IFRS even further. However, if U.S. GAAP accounting is implicated as an ingredient in the crisis, then there may well be momentum to move to IFRS, assuming it survives the crisis.

Q:  If Solvency II-type regulations had been in place in the United States, would the effect of the crisis have been mitigated? 

Wells: At this point nobody knows how this might have played out under Solvency II. What we do know is that Solvency II is a risk-based regime, modeled to some extent on Basel II for banks. I think the crisis will cause a reappraisal of certain aspects of Solvency II (and Basel II), which may well lead to a delay in implementation (i.e., beyond 2012). Several issues are likely to emerge. First, we'll see more focus on credit and liquidity risk; until now, liquidity risk has tended to be glibly treated as little or no risk. Second, the three "S's"—sensitivity, stress, and scenario testing—will become much more prevalent in setting capital levels. Finally, internal models will come under greater scrutiny, and presumably will need to be capable of replicating recent events at an appropriate level of probability. AIG has been in existence since 1919. Who would have said at the beginning of 2008 that AIG would suffer such a dire fate nine months later? Probably no one.

Kelkar: Solvency II-type regulations share many of the same fair-value principles that the IASB is considering for IFRS in parallel to SFAS 157. The subprime market crisis has demonstrated how a severe market disruption, where market liquidity is significantly affected, creates a considerable disconnect between the expected cash flow from a class of securities and its current exit valuation.

For "going-concern" entities such as insurance companies, expected future cash flow is intended to match long-term payout promises to policyholders as part of prudent asset liability management strategies. If regulated entities are required to use exit values in the face of significant market dislocations, the resulting effect on the capital position could be significant. This in turn could lead to unwillingness on the part of insurance companies to invest in illiquid assets.

While Solvency II may reduce insurance investors' appetites for complex securities, including subprime-based assets, it may also reduce their appetites for a broad array of nonstructured but illiquid assets that do not share the same risk characteristics as subprime-based structured securities.

Q:  A credit-default swap (CDS) is a contract under which the seller promises to pay the buyer if there is a shortfall in principal or interest of a referenced bond or security that might be held by the buyer. In those cases where the purchaser owns the bond or security, the swap acts as insurance, because the swap buyer is like a homeowner insuring a home. The New York Insurance Department had determined that, when the buyer owns the underlying security on which he is buying protection, the swap is an insurance contract. What role will actuaries have in helping insurance regulators regulate these instruments?

Wells: Because a CDS can be considered an insurance contract, risk is evident, which, in turn, requires a price be determined in order to transfer all or a portion of this risk. Actuaries are trained to help interpret instruments like these and model their future cash flows. How big a role actuaries play depends on how we position ourselves to the various stakeholders within the industry.

Schwartzman: Actuaries are already involved in reserve, exposure, and capital analyses for financial-guarantee companies, and those types of analyses will be directly applicable to credit-default swaps.

The need to understand correlation of exposures—that is, those guarantees that when triggered are likely to influence the probability that other guarantees will be triggered—will invite extensive analysis, as it is key to understanding loss costs in the tail of the distribution.

Kelkar: Actuaries would likely play a key role in helping FGIs (Financial Guarantee Insurers) comply with the comprehensive new requirements that the New York Department of Insurance has laid down for firms issuing CDS insurance contracts. FGIs will have to maintain sufficient liquidity to pay claims including under extreme-stress scenarios, appropriate risk underwriting and pricing policies, appropriate estimates of anticipated losses, and dynamic risk modeling and sufficient control and remediation rights to mitigate the potential severity of any losses. The Department said that it has established these new guidelines to " ... reverse a trend of apparently inadequate underwriting standards and incautious business practices."

Q:  How will the insurance marketplace react to the uncertainties surrounding the various AIG subsidiaries? In particular, what are the possible effects on the underwriting cycle if AIG is seen as a less viable option to agents, brokers, and risk managers at renewal?

Wells: The AIG situation is incredible, and as I've commented above, the uncertainties it creates—both real (as of now) and in the perception of uncertainty going forward—are potentially massive. In terms of the underwriting cycle, the AIG situation on its own should generate some hardening of rates—though it is presently impossible to say by how much.

Schwartzman: The insurance marketplace operates based on the basic principles of supply and demand. If the recent events influence perceived supply and other carriers do not rush in to fill the void, insurance prices will likely rise.

Q:  What is likely to happen to the E&O/D&O markets?

Wells: We are bound to see more claims—potentially big claims. Rates for banks and insurers will presumably increase to reflect the crisis, even though new tougher regulation will be introduced that we hope can stop the abuses that have occurred recently.

Schwartzman: Financial problems and stock-value declines for public companies always lead to D&O and often E&O claims, so there will be a rash of claims related to these events. Underwriters are already looking well beyond published financial information in evaluating D&O exposures. With the claims influx related to laddering cases, mutual-fund issues, backdating of stock options, the Enron bankruptcy, and related financial problems, insurance company underwriters are reviewing company board minutes and other internal documents in the underwriting of a company's D&O protection. Recent events will certainly put more pressure on D&O underwriters to raise rates in light of the claims activity, but there has been little evidence thus far that companies are rushing to do so even in light of all the subprime-mortgage issues.

Meanwhile, some carriers are now taking steps to attract AIG's clients by offering increased capacity. This is contrary to what we saw after Enron, when carriers cut limits to temper aggregation exposures; whether this proves to be a short-term play for more business or a long-term trend remains to be seen. It will most certainly lead to a greater use of reinsurance in the short term to spread the risk. Ironically it is this same spreading of risk—a founding principle of insurance and reinsurance products—that has contributed to the enormous reach of this financial crisis. 

Q: What role did FASB Statement No. 157, Fair Value Measurements, play in this crisis?

Kelkar: Financial Accounting Standards Board Statement No. 157 (SFAS 157) has a laudable goal of providing better visibility into the true value of assets on balance sheets. The current crisis is undoubtedly the result of lax credit standards, questionable mortgage products, excesses in mortgage lending, and a general lack of transparency. On the other hand, there is ample evidence to suggest that valuation under SFAS 157 may have been a source of volatility, especially in instances where there was no market or a very illiquid market for certain classes of securities.

For example, many banks have taken significant write-downs for their subprime mortgage investments as a result of using the ABX.HE Index as a guidepost. This index represents a standardized basket, which is a subset of just 5% or so of the overall universe of subprime home equity Asset Backed Security reference obligations. Yet a Bank for International Settlements research paper suggests that observed ABX prices are unlikely to be good predictors of future default-related cash-flow shortfalls, especially for higher-rated tranches.

The FASB definition of fair value is the "exit" price or "the price that would be received to sell an asset or paid to transfer a liability." In many cases, the new rule has created a virtual death spiral whereby a distressed sale by one investor forces others who chose to hold the assets to reconsider their mark-to-market valuations. The SEC issued a clarification in March 2008 to the effect that "fair value assumes the exchange of assets or liabilities in orderly transactions ... it is appropriate for you to consider actual market prices ... unless those prices are the result of a forced liquidation or distress sale." Nevertheless, exceptions to the general rule of using actual market prices require the advice and consent of auditors, and such an outcome is less likely under troubled market conditions when most accounting firms quite appropriately lean toward a more conservative approach.

Wells: Presumably the whole concept of fair value will need to be carefully rethought. In the present crisis, certain so-called tradable securities (in particular corporate bonds) cannot always be traded, even where prices were quoted. For nontradable liabilities (e.g., claims reserves), the market-value margin (MVM) will need to be reappraised. All else being equal, I would expect the MVM to increase, which will have an adverse impact on insurer balance sheets.

Q: What effect will the tightening of credit markets have on European companies in the short and long term?

Wells: In the short term we will see three factors. Balance sheets will come under increased stress and scrutiny. That, coupled with a more cautious view of the business environment in 2009, will slow down activity. The crisis is likely to result in greater regulatory scrutiny and action on companies with weak solvency positions. The AIG situation may well lead to opportunities for those European insurers with stronger balance sheets to make acquisitions and grow their presence/business.

In the longer term, presumably the crisis will eventually dissipate and companies will carry on business in a more orderly manner, but perhaps never as they did in the past. Regulation is likely to strengthen, the market is likely to consolidate, and we may see greater regulatory capital requirements. The whole concept of financial risk management will be redefined in the areas of credit, liquidity, and margins.

Q: Some insurance carriers have investments in mortgage-backed securities (MBS) and other collateralized debt in their asset portfolios. What impact, if any, will we see on the value of those assets going forward? 

 Wells: These assets are at the center of the problem and they have caused contagion in other asset classes (e.g., corporate bonds). The problem is that it is very difficult to value these securities while property prices keep falling. When property prices stabilize, market values can be determined. But when will that be? Until then, capital positions will face continued stress and increased uncertainty.

 Kelkar: Insurance company holdings of MBS and structured securities such as CDOs have already been written down in value to the extent that there was a belief that a permanent impairment in value has occurred because of an erosion in collateral value. Further significant deterioration in asset values based on market conditions could cause additional other-than-temporary write-downs. The extent of additional write-downs is difficult to predict given the ongoing turmoil in real estate and banking markets, but it is possible that markets have over-reacted as they usually do and thus current mark-to-market levels may have already overshot expected loss estimates. According to Lehman-Barclays Capital research analysts, insurance companies hold only 10% of total outstanding residential debt and only 5% of the losses, primarily because of the tighter regulatory controls and capital requirements prevalent in the insurance industry.